2023-09-28 01:06:24 ET
Summary
- My End-of-2022 prediction for the S&P to trade at around 4,200 points by the end of this year seems to be right on track as we head into Q4.
- The Federal Reserve's assumed plans to gradually stop fighting inflation and perhaps support a stagnating economy will likely be derailed by rising oil prices.
- Geopolitical frictions, particularly in Europe and China, could disrupt global supply chains and lead to shortages in consumer goods, which could amplify inflationary pressures.
- I am currently invested heavily in oil stocks, while I also hold a significant cash position, as I expect stock market stagnation in Q4 to give way to a down year in 2024, which could provide good entry points for investors.
Investment thesis: As we head into the last quarter of the year, I decided to take stock of one of my main end-of-2022 predictions for this year, namely that the S&P 500 ( SP500 ) will finish the year at 4,200 points. We are currently about 2% above that level, meaning that for the last quarter of the year, the S&P will have to retreat by that much for my prediction to be considered to be close to the target. In other words, the S&P will trade more or less sideways if I am correct. Looking at several factors, some of which I highlighted in my original prediction as being potential factors that will take us there, I'd say that my target of 4,200 points for the index remains a very probable outcome, which will then take us into a potentially rough investment environment next year.
S&P trades at a historically high P/E level, despite the higher interest rate environment.
Through much of the last decade, the S&P traded at a much higher P/E level than was historically the case through most of the post-WW2 era.
S&P 500 P/E chart (Multpl.com)
The higher valuation levels were often, perhaps correctly excused by citing the low-interest rate environment that persisted in the post-2008 financial crisis era. Warren Buffett was famously quoted as stating that the market was not overvalued given the low costs of borrowing.
The basic theory behind it is that cheap money allows companies to borrow & invest at low cost, while profit margins are not being squeezed by interest on debt, and it also allows investors to borrow cheap money to invest, both factors combining to make for a supercharged stock market boom. Risk is also greatly diminished, given that one of the main factors that tend to cause companies to fail is the burden of carrying debt. When that becomes overwhelming, companies tend to fold. As we can see, between 2010, right after the financial crisis and the present, corporate debt volumes more than doubled, which is a reflection of the fact that cheaper debt became much easier to carry.
Federal Reserve Bank of St. Louis
We are currently sitting at yields on the 10-year Treasury notes that we have not seen since 2007, at around 4.5%, thus, we are arguably experiencing an overvalued market environment. Historically, the mean P/E ratio has been just over 16. This by itself does not necessarily mean that an imminent stock market selloff should be expected. It probably means that at some point, a normalized interest rate environment, such as what we are arguably seeing right now, will eventually lead to a normalized P/E ratio for stock indexes, in other words, get closer in terms of valuations to the historical trends.
Everyone still watching the Fed, even though it is now simply reacting to prevailing circumstances.
Part of the reason that the S&P 500 index saw a significant decline, of roughly 7% so far in September is that the Fed signaled it is not yet ready to pause and even perhaps reverse its monetary tightening policy as many investors might hope to see. The market reacted negatively, even though the Federal Reserve is just reacting to other factors that are threatening to push inflation higher again. Rising energy prices as well as geopolitical tensions that threaten to severely disrupt the global supply chains, could potentially unravel all the work that central banks around the world have done to try to contain inflation.
The most immediate and obvious threat to our efforts to contain inflation is the continued rise in oil prices.
A recent JP Morgan Analyst prediction suggests that oil prices could rise much higher from current levels, perhaps to $150/barrel by 2026. I tend to agree with the price prediction, however, I expect that we could reach that level at some point next year, in the absence of a severe demand destruction event.
The $20/barrel increase in oil prices since June is already starting to affect inflation. For the first time since Inflation started to move off its June 2022 peak, inflation rates started edging higher again in the summer coinciding with the rising cost of oil.
Rising oil prices will sustain inflationary pressures since oil plays a very significant role in the production and distribution of most tangible goods. The only chance for us to see inflation rates start to decline back toward the desired rate of about 2% is for energy prices as well as other commodity prices to start retreating significantly from current levels. As long as the opposite is the case and oil & other commodities prices will continue to push higher, it will also push overall inflation rates higher. We might get to the point where after raising interest rates again this year, instead of signaling a pause in interest rate hikes, the Federal Reserve will signal more monetary tightening.
On another front, sometimes related to commodities prices, sometimes not, geopolitical frictions are also emerging as a rising threat to global supply chains. We have the very obvious situation where Europe will always be one particularly harsh winter in the Northern Hemisphere away from experiencing a potentially catastrophic energy shortfall crisis, mostly due to its economic divorce from Russia. The reason I am focused on the entire Northern Hemisphere is because it might not even be triggered by a very cold European winter, but rather by a very cold North American winter, which can lead to a stoppage in LNG exports from the US to Europe.
There are rising frictions between the Western Alliance and China and China is now starting to retaliate, with its first shot fired in this economic war being the cut in the exports of materials used in semiconductor production, which could eventually lead to semiconductor shortages. We also have other flashpoints, such as Niger, where uranium supplies are coming under threat, as well as the Azerbaijan-Armenia situation, where energy exports could potentially be affected. These are just some of the recent examples of flashpoints around the world that seem to be multiplying and intensifying.
As long as there was no supply constraint issue on the global market after the 2008 financial crisis, the much-feared spiraling of the economy into hyperinflation never materialized. Most of the money that Central Banks pumped into the economy ended up finding its way into the stock markets and other assets, such as real estate, where it arguably helped create the only inflation we saw last decade, namely asset inflation. For those who are interested in further exploring this subject of low accommodative central bank policies causing asset inflation, I find an explanation issued by the ECB regarding the effects and possible risks to be most enlightening.
Now that interest rates are higher than they have been at any point in time since 2007, in theory, there should be some gradual rebalancing in the pricing of assets. This does not seem to be the case just yet, and perhaps the main culprit is that the market still expects a reversal to occur, rather than accepting this as being the new normal for the foreseeable future.
S&P is not likely to undershoot the 4,200 target by the end of the year.
While most of my argument here is focused on why the S&P is likely to slide down from current levels, the obvious counter-argument to my 4,200 point target to the end of the year would be that if I prove to be correct in my thesis, then perhaps the risk to my target might be on the downside. If my original forecast had set an end-of-2024 target, I would have to agree that there is a very real risk that by then we will undershoot that price level for the S&P, for many of the reasons I laid out. For now, however, we are just starting to feel the effects of inflation starting to show signs of reversal and heading back up again.
The Federal Reserve is similarly just starting to adjust to this reality. It will probably keep its pledge by raising rates one more time this year. More importantly, I believe that it might start to hint at more interest rate hikes next year, or at least hold steady, in response to what might be a few upward surprises in terms of inflation rates in the last months of the year. This will keep the stock markets from rallying from current levels in the fourth quarter while ongoing uncertainty about what actions the Federal Reserve will take going forward will prevent the market from selling off too aggressively. Once we look beyond the Federal Reserve and look at the fundamental factors that could push inflation trends higher, we get a better picture of what the Federal Reserve is likely to do for the rest of this year and perhaps in 2024. It will continue to react to ongoing trends, rather than being the trendsetter, even though the markets see it as such.
In conclusion, with three months to go, the Federal Reserve will not have too much of a reaction to the reversal of inflation back higher than we are seeing. It is still gradual and factors such as rising oil prices will take time to work through the economy and push prices higher more broadly throughout the economy, thus the Federal Reserve's reaction to it will most likely become clear only next year.
Investment implications:
If my thesis is correct, a broadly diversified portfolio will amount to stagnated money for the rest of the year, with next year most likely being a tough one for investors. For the past year, I mostly tailored my portfolio to reflect my expectations that the market will be headed more or less where we are right now, and just slightly lower from current levels by the end of the year, for the specific reasons I laid out then .
One of my main bets was that commodities prices are likely to remain high or even push higher, which is what we are starting to see now, particularly in the case of oil. As such, I maintained an outsized position in oil stocks for the entire year, with Suncor ( SU ) being by far my largest stock holding, accounting for about a fifth of my entire stock portfolio. CNQ ( CNQ ) is my other major oil position. I also have a much smaller position in Chesapeake ( CHK ), which is mostly a bet on Europe's desperation for LNG supplies.
I am also keeping a sizable cash position, equivalent to about 25% to 30% regularly. For the rest of the year, I see the stock market going more or less nowhere. There is certainly not much of a prospect for significant upside as far as I can tell. I expect that next year will be outright painful for stocks, as it becomes increasingly apparent that the S&P needs to retrace back to a more historically typical level in terms of metrics such as the P/E ratio, in response to interest rates remaining persistently higher than we have seen in the past decade. It will also have to do it within the context of a stagnated US economy. I expect stocks to head lower next year, which will provide investors with buying opportunities, making it desirable to have a sizable cash position.
Regardless of how bad the prospects for the market might appear, there will always be potential opportunities. I recently covered the SHY, and ISHG sovereign bond ETFs, both of which could work as a bet on a recession next year, which could trigger at least a temporary decline in interest rates. Declining interest rates would mean that higher interest-yielding bonds held in these ETFs will gain in price, thus both ETFs should head higher within the context of an impending recession. I am also keeping an eye on VinFast ( VFS ), the Vietnamese EV upstart, which I see as increasingly reaching a pricing level that might be worth taking a risk on, regardless of where we might be along the economic cycle curve.
Given where I see the market heading for the remainder of this year and beyond, the one investment strategy that is unlikely to produce stellar results for the foreseeable future is the classical, well-diversified portfolio that reflects more or less the performance of the broader market indexes. It might not look too bad for the remainder of the year if I am correct, but 2024 is increasingly shaping up as a potentially terrible year on the US and global macroeconomic front. If my prediction of the S&P trading at around 4,200 by the end of the year turns out to be correct, these few months could be a valuable prelude for investors, to a potentially far more dangerous investment environment. It can provide the time needed to weatherize one's portfolio for the coming storm.
For further details see:
My Prediction For S&P 500 To End Year At 4,200 Looks Realistic